Contributing editor Ryan Irvine is back this week with a look at the promising world of U.S. small cap stocks. Ryan is the CEO of KeyStone Financial (www.KeyStocks.com) and is one of the country's top experts in small caps. He is based in the Vancouver area.
Over the past six months, KeyStone analysts have reviewed thousands of U.S. listed companies including the entire Russell 2000 Index. We have also looked at all small and mid-caps listed on Nasdaq and about 1,700 over-the-counter (OTC) listed companies. In total, we reviewed well over 4,000 stocks.
Our standard minimum criteria of ongoing profitability applied. KeyStone's bias toward strong, cash-rich balance sheets with solid cash flow growth also weighed heavily for inclusion purposes.
Before we delve deeper into the valuation criteria, let's take a quick look at some broader findings from the research as they relate to the U.S. and Canadian markets.
A far greater percentage of U.S. companies are actually profitable. This is a significant advantage that U.S. markets possess in terms of actual analysis of cash flows, balance sheets, etc., when compared to Canadian stocks. The Canadian markets consist of roughly 4,000 individual companies on the TSX and Venture exchanges. The large number of companies in the junior mining and oil and gas industries, as well as junior tech and biotech, results in a very high proportion of stocks that are either pre-revenue, currently posting very small sales, or reporting sales but nowhere near profitability.
Generally in the U.S. market, particularly on the larger exchanges such as the NYSE and Nasdaq, this is not the case. The vast majority of the companies passed our minimum criteria of profitability, whereas a great number in Canada are immediately excluded. U.S. OTC-listed companies were the exception with most of them resembling the highly speculative companies that make up most of the TSX Venture or worse.
The U.S. market possesses far more publicly listed banks and related finance companies than Canada. This is another significant difference between the Canadian and U.S. small cap markets. The U.S. boasts a number of regional banks that have some attraction, but there are also a large number of city-based banks and finance companies with only one or two locations. Due to their relative size (extremely small) we removed most of these very thinly traded financial companies from our U.S. coverage universe. In Canada, the banking sector continues to be dominated by the big six banks, due in large part to the regulatory structure.
Average balance sheet strength is greater in the U.S. than Canada. This does not mean they are necessarily better companies, just that they appear to be better funded. Access to capital appears greater. In fact, within a recent U.S. small-cap report, 21 out of 32 companies selected held strong net cash positions (cash minus debt). A number of these held over a quarter of their market capitalization (market value) in cash.
The U.S. market overall is much more expensive than the Canadian market. There are a number of reasons for this including access to capital, but it can make the job of a growth/value analyst more difficult. While there are plenty of growth stocks in the U.S. market, most are currently trading at what we would consider to be inflated valuations. Of course, this can be dependent on how one defines earnings, but from a traditional perspective, the broader U.S. market is historically offering little value based on growth estimates.
Currently, most individual stocks with decent growth profiles and strong balance sheets trade at 40 to 50 times earnings, in some cases much higher. The few that appear to be actually cheap on the surface generally have some form of overhang or "warts" in the story.
Our strategy when applying the valuation criteria for this report was to focus on growth at a reasonable price as opposed to pure value. What that means is that we were willing to look at companies with somewhat more expensive valuations as long as the growth and other fundamentals provided the justification.
At a certain level, around 40-plus to 50-plus times earnings, the investment risk increases unless the growth is reasonably certain. For example, a company that trades at 50 times earnings but is growing earnings per share at 50% to 75% per year is not actually that expensive relative to the growth rate.
However, that level of growth is very difficult to maintain for an extended period of time. If the growth were to decline to the 15% to 25% range, then there is a significant risk that the valuation would contract and the share price would fall even though earnings are continuing to grow at an impressive rate.
We are seeing the most value in the companies trading at 15 to 25 times trailing earnings multiple with strong growth rates and fundamentals. Although 20-plus times earnings is not generally considered cheap for our style of research, it can still be very reasonable if the underlying fundamentals and growth of the company justify it.
Without further ado, we introduce a new U.S. stock to our coverage universe –Â one of the products of our recent report on the U.S. growth stock market.
Background: TrueBlue Inc. (TBI, Financial) is a leading provider of specialized workforce solutions including staffing, large-volume on-site workforce management and recruitment process outsourcing to fill full-time positions. The company helps approximately 130,000 businesses, in a wide variety of industries and geographies, be more productive and connects as many as 840,000 people to work each year.
TrueBlue consists of two business segments: Staffing Services and Managed Services. Staffing Services provides a wide range of blue-collar staffing services including general labor, light industrial, skilled trades, aviation and transportation mechanics and technicians, and drivers as well as on-premises staffing and management of a facility's contingent blue-collar workforce. Managed Services includes outsourced service offerings in permanent employment recruitment process outsourcing (RPO) and management of contingent labor services providers (MSP).
Investment highlights: Here are some of the key points that caught our attention:
- Record fourth quarter and annual results in 2015.
- Strong organic growth: 14% for the fourth quarter and 7% for the year.
- Completed two acquisitions in 2015 to expand services; expected to generate accretive growth in 2016.
- 2016 guidance of $3.1 billion (an increase of 16%) for revenue and $2.65 per share (an increase of 31%) adjusted net income.
- Attractive valuation coupled with positive outlook and solid opportunities for future growth.
Financial overview: TrueBlue reported record financial results for the fourth quarter and full year of 2015. Revenue increased 17% in the fourth quarter to $811 million. Full-year revenue was a record $2.7 billion, an increase of 24% compared to 2014. The company achieved strong organic growth in 2015 of 14% in the fourth quarter and 7% for the full year. Adjusted EBITDA rose 6.1% in the fourth quarter to $46 million. Full-year adjusted EBITDA increased 23% to $147 million. Adjusted net income per share for the fourth quarter was 66 cents, up 6.5% from the same quarter last year. Full-year adjusted net income per share was $2.02, an increase of 21% compared to 2014.
Within TrueBlue's core business, the company reported widespread growth serving the specialized staffing needs of small to midsized customers. The growth also continued to be widespread throughout the company's geographies, with strong momentum in both local and national accounts. Construction was strong with double-digit sales growth in the fourth quarter. Although manufacturing has declined year over year, the company did report low-single digit declines versus slightly higher declines earlier in the year in that industry segment.
TrueBlue is expecting another record year in 2016 with significant year-over-year growth in key financial metrics. For the full year, TrueBlue is estimating revenue of $3.1 billion and adjusted earnings per share of $2.65, representing year-over-year growth of 16% and 31%. For the first quarter of 2016, the company is estimating revenue of $660 million to $675 million, an increase of 15% to 18% and adjusted net income per diluted share of 23 cents to 28 cents, an increase of 15% to 40%.
Historically, we have been able to trace the company's financial history back 22 years to 1994. Over this period, the company was profitable in all but a single year (2008). Revenue, while exhibiting some volatility, has traveled on a relatively steady trend upward. Earnings have been more volatile, and we saw a sharp drop in 2008, which was the start of the financial crisis and "great recession." It is clear from the historical data that there is a strong element of economic sensitivity in the business.
Key areas of growth: Acquisitions are an important aspect of TrueBlue's growth strategy with the company averaging one transaction per year since 2012. The company has completed two acquisitions in recent months, both of which are expected to deliver significant accretion to earnings per share this year.
On Dec. 1, the company acquired SIMOS, a leading provider of on-premise staffing solutions for several Fortune 500 companies. SIMOS is on the cutting edge of using contingent labor to increase performance. On Jan. 11, TrueBlue acquired the recruitment process outsourcing (RPO) business of Aon Hewitt. This acquisition is a part of the company's initiative to further position PeopleScout (acquired in 2014) as the leading global RPO provider with more than $150 million in annual revenue and 300,000 annual full-time placements.
TrueBlue believes the RPO market has tremendous potential on a worldwide scale. In addition, the SIMOS acquisition complements the work that the company is doing to offer businesses large scale on-premises management with a focus on improving productivity. Together, the company expects that these two acquisitions will increase 2016 adjusted earnings by 34 cents per share, or 17% over 2015. Over the next six months, management's strategy is to focus on the recently completed acquisitions to ensure customers and employees are retained and relevant integration activities are completed to enable future growth.
Management believes that success with these activities will provide capacity to complete economically priced deals in the future that provide unique value to customers yet are complementary to the company's current portfolio of services.
TrueBlue has also made significant investments into personnel and technology. Investments for growth include the development of technology to connect with both the company's current workforce and candidates alike by moving from a texting system to an app built for smart devices. Investments were also made into additional professionals on the ground, selling and recruiting. Since the end of the first quarter of 2015, 300 new positions have been added in the branch-based staffing business, predominantly in higher paid sales and recruiting positions. These investments, while successfully generating organic growth, also resulted in a decline in EBITDA margins in 2015. Management is confident that the company is investing in the right areas; however it has decided to pull back slightly on certain costs to ensure that adjusted EBITDA margins can be maintained at the current level during 2016.
Strong profitable organic growth continues to be a top priority for the company due to the solid shareholder return it produces.
TrueBlue believes one of the most remarkable changes in today's employment market is the growing use of contingent workers alongside the permanent workforce for businesses of all sizes. The company views this is a growing trend that has been in the marketplace for many years, driven in part by two factors. One is the retirement of Baby Boomers, whose skills are not being replaced by the next generation of workers. The second is the interest of the next generation, and the companies who employ them, in greater flexibility. The company also reports that this change has been accelerating rapidly over the past few years and is on its way to becoming the standard way businesses will operate in the future.
This broader use of a blended workforce has also increased the need for services beyond simply filling positions, including the recruiting and management of large-scale contingent workforces for individual projects or locations, as well as recruiting high numbers of top candidates to fill permanent positions. The company sees tremendous long-term opportunities helping its clients adapt to the changing marketplace and believes it will continue be a beneficiary of this trend.
Conclusion: TrueBlue reported record performance in 2015 capping off the sixth straight year of higher revenue and earnings. Based on management's guidance, 2016 is shaping up to be another record year with earnings expected to increase 30% over 2015. TrueBlue currently maintains a significant amount of operating momentum in its business, which has been driven by growth initiatives implemented by the company and an improving employment market in the U.S. The company views this as a growing trend driven by changing demographics and the need of companies and workers for more flexibility and reports that the change has been accelerating rapidly over the past few years.
On a price-to-earnings basis, the company is trading at or below the lower end of its historical range, which indicates to us that there is strong potential for valuation expansion if it can maintain its current revenue and earnings momentum over the next one to two years.
The main risk we see with the stock is economic sensitivity as the industry has demonstrated cyclicality in line with the business and employment cycle. Although TrueBlue's revenue and earnings have risen and declined with the economy, we are impressed by the long-term track record of 21 out of 22 years of profitability as well as the achievement of higher revenue and earnings peaks through each cycle.
The company because it has a rare combination of growth and value. As long as the economy keeps limping forward at even a moderate pace, we see excellent potential for short-term returns to shareholders of TrueBlue. On a longer-term basis, there is the risk of cyclicality (which exists for nearly all companies), but the company has navigated these risks very well in the past and proven itself to be a value generator over time.
Action now: Buy. The stock closed on Friday at $21.02 per share.
